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Hicks: We might be headed for another financial crisis

October 11, 2014

Nowadays, about three-quarters of households will eventually own retirement plans. This makes most of us dirty capitalists who wish to see our retirement funds grow. This motivates us—or more typically the financial firms that manage our funds—to seek out the optimal mix of risk and reward for our hard-saved dollars.

Today’s financial markets offer few good choices for retirement investments, and that is both a symptom and cause of a problem.

Stock markets in the United States are hovering at near-record levels. But there is real reason to worry.

While any investment adviser will tell you that the price-to-earnings ratio (a measure of how much the average stock costs relative to its rate of return) is not especially high, that should be scant comfort. Something called the cyclically adjusted price-to-earnings ratio (developed by Nobel Laureate economist Robert Shiller) is at alarmingly high levels. In fact, the only three times the measure has been higher in the past century were in 1929, 2000 and 2007. Worried yet?

How can it be that we might be back in financial-bubble zone, and what on Earth is going to happen?

Despite election-season exuberance over jobs numbers, the simple fact is that labor markets are progressing poorly and the economy is a long way from solid. Potential workers continue to leave the formal economy at a shocking pace, and wages are effectively unchanged from last year.

This has led the Federal Reserve to maintain a loose monetary policy, meaning lots of money is floating around the economy and depressing nearly all interest rates around the world. On Oct. 7, the International Monetary Fund again downgraded global growth, warning of “frothy” stock markets.

To put it plainly, investors have few other places to invest other than the stock market. So more buyers seem to enter the market each day.

With growing evidence of a global slowdown, there is plenty to fear from a stock market bubble. Sadly, there’s no good way to say how or when financial markets will respond, and no one has developed a model to predict bubbles.

Perhaps a slow and careful effort by the Federal Reserve to raise interest rates could boost investor confidence. It might spark a run for safe investment options, which is the bursting of a bubble. A black swan event such as a major war or significant terror attack is far more worrying.

The only certainty is that we are in a challenging and forbidding period in financial markets. So, don’t get too exuberant over that retirement fund statement.•

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Hicks is the George and Frances Ball distinguished professor of economics and director of the Center for Business and Economic Research at Ball State University. His column appears weekly. He can be reached at cber@bsu.edu.
 

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